China’s reform blueprint has been well received by economists and investors more for what they hope it will lead to than for the cautious changes actually promised.

Its reform of the financial sector, rural property rights, the hukou household registration system, and the one-child policy are an entry-level version of the profound and unprecedented reform foreshadowed by
Yu Zhengsheng
and other senior officials.

Yet Yu, whose predecessors as chairman of the National Committee of the Chinese People's Political Consultative Conference include Mao Zedong and Deng Xiaoping, would understand the dynamic that has been unleashed.

The reforms announced by President
Xi Jinping
may be limited, vague, and hedged with reassurances about the continuing role of state-owned enterprises, but the new, relatively small wave of change will create pressure for further reform.

AFR
AFR

Everyone now agrees that China cannot afford another “lost decade" of inaction.

While accepting that the Chinese authorities still have the policy tools and fiscal space to address potential economic shocks, the International Monetary Fund warns that maintaining the current rapid and unbalanced growth would “further strain financial sector, government, and corporate balance sheets."

“Failure to change course and accelerate reforms . . . would thus increase the risk of an accident or shock that could trigger an adverse feedback loop. For example, financial distress would lead to a contraction in credit, a fall in domestic demand, and lower growth, which would make it more difficult for highly leveraged borrowers to grow out of their debt."

Similarly, the former World Bank country director for China, Yukon Huang, dismisses talk of financial crisis and collapse, but agrees on the need to address the distortions in China’s economy to change “the mix of investment in favour of the private sector and services, supporting a more efficient urbanisation process, including more liberal migrant residency policies."

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“Such actions would moderate the excessive growth in infrastructure expenditures in the more remote secondary cities and encourage more concentrated development of urban services in the major cities, which would stimulate consumption."

Finance, land, and housing reforms

So exactly what reforms should the Chinese leadership now be reaching for?

In a detailed briefing for clients, Deutsche Bank’s Michael Spencer, who is based in Hong Kong, argued before the Third Party Plenum that financial liberalisation, land reform, and reform of the “hukou" system of household registration would be high on the new administration’s list.

As Spencer saw it, financial sector liberalisation would be the most significant part of a serious reform agenda because it would lead to a redirection of credit away from the state-owned enterprises to the capital-constrained private sector.

Private enterprise accounts for 70 per cent of China’s gross domestic product but gets only about 20 per cent of bank credit.

This bias in the distribution of credit, Spencer says, is a major constraint on growth because the state-owned enterprises are either in sunset industries like coal mining, iron ore and steel, or are losing market share to the private sector.

The full liberalisation of finance would see funds flowing into the more labour-intensive small- and medium-sized enterprises in the service sector, which would create jobs and increase consumer spending.

As Spencer says, the key to financial reform will be the “eventual" full deregulation of deposit rates. The current benchmark deposit rate underpins the supply of artificially cheap credit to state-owned enterprises and effectively taxes households by providing a low or, more often than not, negative real rate of return on their savings.

Rural reforms vital

Like other economists, Spencer also emphases the critical importance of full rural land reform. Granting transferable rights to rural property, he says, would represent the largest single transfer of wealth in human history and would generate a significant boost in consumption spending.

It also would lead to improvements in agricultural productivity as farms were aggregated and made more capital intensive, and a more permanent migration of surplus labour to work in the factories and new service industries in the cities.

But the reform of hukou is essential if rural land reform is to play its full part in driving growth.

Hukou divides the populace into rural and urban residents, primarily according to place of birth, which denies migrant workers and their children full access to education, health and other services in the cities.

Migrant workers will be less willing to sell their rural assets if they and their children are denied the full rights of permanent residents in the cities.

The authorities are treading carefully, with promises that the state will continue to dominate the “commanding heights" of economic activity, pilot studies of rural land reform, and with hukou reform restricted to secondary cities.

But, as Spencer says, genuine liberalisation of the financial system will deliver the much needed restructuring of China’s industry.

And successful hukou reform in the secondary cities should pave the way for more comprehensive change.

Hukou reform has been strongly opposed by city residents jealous of their well-paid jobs in state-owned enterprises and their superior education and health care systems.

The need to overcome those objections will increase the pressure for further fiscal reform, as well as the financial and regulatory reform needed to expand employment in the service sector.

One cautious reform will create pressure for another.

In Association with The Australian Financial Review, the Australian Business Economists’ annual conference and dinner in Sydney on Thursday will feature the Reserve Bank governor, Glenn Stevens, the IMF’s Min Zhu, the Treasury’s David Gruen, and the Grattan Institute’s John Daley. Bookings close Monday 6pm: www.abe.org.au